Credit Rationing

11 Key excerpts on "Credit Rationing"

• 

  eBook - ePub

  Information Economics

  Decoding Data, Mastering Information Economics for Informed Decisions

  • Fouad Sabry(Author)
  • 2023(Publication Date)
  • One Billion Knowledgeable

    (Publisher)

  Chapter 17: Credit Rationing

  By definition, Credit Rationing is limiting the availability of additional credit from lenders to borrowers who request cash at a specific quoted rate from the financial institution.

  The phenomena of credit restriction is distinct from the more well-known case of food rationing. While food restriction is the consequence of direct government action, Credit Rationing is the product of asymmetric knowledge. Through a procedure known as credit assessment, lenders can reduce the danger of asymmetric knowledge about the borrower when they ration credit. Applying a predetermined criterion to an application results in either a loan acceptance or denial once credit assessment is finished during the loan application process. It is crucial to remember that credit evaluation is one method the lender uses to lower the risk of loan default and is thus an illustration of how lenders may actually implement Credit Rationing.

  There are typically three primary categories of Credit Rationing:

  The most fundamental type of credit restriction takes place when the lender's capital quality is negatively impacted by a considerable decline in the value of the collateral given by the borrowers. Collateral gives the bank assets that satisfy the minimal standards imposed by regulators, and it is frequently used to determine the loan's LVR (Loan to Value Ratio). Increased Credit Rationing may result from drops in the value of the collateral given to a financial institution. This is because the lender's risk of financial loss increases should the borrower default and the financial institution may not be willing to extend future loans if the collateral (or security) provided to the lender decreases in value, affecting the LVR of the loan.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  The Economics of Banking

  • Kent Matthews, John Thompson(Authors)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 8 Credit Rationing MINI-CONTENTS 8.1 INTRODUCTION 8.2 THE AVAILABILITY DOCTRINE 8.3 THEORIES OF Credit Rationing 8.4 ASYMMETRIC INFORMATION AND ADVERSE SELECTION 8.5 ADVERSE INCENTIVE 8.6 SCREENING VERSUS RATIONING 8.7 EMPIRICAL EVIDENCE 8.8 THE EXISTENCE OF Credit Rationing 8.9 SUMMARY 8.1 INTRODUCTION The notion of Credit Rationing developed as a side product of the view that monetary policy has strong direct effects on the economy through the spending mechanism. The view in the 1950s was that monetary tightness could have strong effects on reducing private sector expenditure even though interest rate changes were likely to be small. The reasoning behind this was that banks restrict credit to borrowers. This was the basis of the so-called ‘availability doctrine’ which roughly stated says that spending is always in excess of available loanable funds. Indeed, it was noted by Keynes (1930) that ‘there is apt to be an unsatisfied fringe of borrowers, the size of which can be expanded or contracted, so that banks can influence the volume of investment by expanding and contracting the volume of their loans, without there being necessarily any change in the level of bank rate’. The question that troubled the economist was: Could Credit Rationing be consistent with the actions of a profit-maximizing bank, as it appeared to be inconsistent with basic demand and supply analysis, which postulates the existence of an equilibrium rate at which all borrowers, who are willing to pay that rate, obtain loans? The principal aim of this chapter is to address this question. However, at the outset we should distinguish between two types of Credit Rationing. Type 1 Credit Rationing occurs when a borrower cannot borrow all of what he or she wants at the prevailing price of credit, although he or she is willing to pay the prevailing price.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  Credit and Collateral

  • Vania Sena(Author)
  • 2007(Publication Date)
  • Taylor & Francis

    (Publisher)

  Therefore, financial institutions cannot use the interest rate as a variable that allows either to sort borrowers according to their riskiness or as an incentive mechanism; so at the end they have to resort to Credit Rationing to avoid potential future losses. Thus some borrowers will be rationed in equilibrium with the result that they will not get the necessary financial resources to carry out their productive activities. Afterwards, a substantial empirical literature has analysed the implications of the financial constraints due to informational imperfections on both firms’ productive activities and business formation, among the many possible activities. 3 As it has been pointed out by Nickell and Nicolitsas (1999), the main impact of Credit Rationing is that of increasing the cost of borrowing for both firms and consumers and this of course has a direct, adverse impact on both the investment activity and the formation of new firms. Indeed, the theoretical models on Credit Rationing entail a clear prediction on the characteristics of the economic agents that are likely to be rationed in equilibrium: typically, young and small firms may be constrained in their access to external financial resources as lenders may consider young age (and so lack of track record) and small size as signals of the inexperience of these potential borrowers and so of the riskiness of the investment projects proposed by them (Fazzari et al., 1988 ; Hubbard and Kashyap, 1992 ; Schaller, 1993 ; Gilchrist and Himmelberg, 1995 ; Hubbard et al., 1995). Equally, potential lenders may be reluctant to support financially the creation of new firms as it is difficult for them to assess the future market prospects of these new companies and therefore their relative riskiness (Evans and Jovanovic, 1982; Goldberg and White, 1998)

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  An Analysis of Credit and Equilibrium Credit Rationing

  • Ying Wu(Author)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  fall as credit becomes tighter. When rationing occurs, increased credit market tightness will cause both the loan rate charged by intermediaries and the deposit rate paid by intermediaries to decline. Furthermore, although loan rates behave as normally expected when credit is not rationed (they increase as credit becomes tighter), there exists a range of loan supplies over which the rate of interest paid by intermediaries to their depositors falls as credit becomes tighter.

  These findings enhance the attractiveness of equilibrium Credit Rationing as (at least part of) the answer to some important macroeconomic puzzles. Credit Rationing may help explain the difficulties encountered in empirically verifying the conventional view that real interest rates and investment are negatively correlated. And the spate of recent work incorporating Credit Rationing into macroeconomic models suggests that some economists believe equilibrium Credit Rationing may offer an improved story about how changes in money (or, more broadly, aggregate demand) are transmitted to the real economy.1 In this larger context, the contribution of this chapter is to point out that the testable implications of a theory that incorporates Credit Rationing may depend on the form the rationing takes. If rationing takes the form of restricting loan size, the theory may be consistent with observing a positive relationship between interest rates and loan supply during periods of significant rationing.

  It is evident that the novel results developed in this chapter depend critically on the assumption that rationing may take the form of restricting the size of loans rather than the number of loans made by an intermediary. Early writers such as Guttentag (1960) and Hester (1967) emphasize the importance of restricting loan size as a rationing device. Furthermore, Hester points out that assuming that banks ration solely by increasing loan rejections contradicts the results of available survey data.2 It is also noted that in the theoretical framework presented in this chapter there is no a priori

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Economics of Banking

  • Hans Keiding(Author)
  • 2017(Publication Date)
  • Red Globe Press

    (Publisher)

  Chapter 6 Credit Rationing 6.1 Access to credit and supply of credit One of the apparent puzzles of banking theory is that although lending in the financial sector is largely confined to private enterprise and guided by considerations of profit maximization, the market for credits is not balanced through the working of the price mechanism. Individuals may be denied credit even if they are willing to pay arbitrarily high interest rates. Thus, the market does not achieve equality of demand and supply; there is no value of the price charged in this market, that is, the interest rate – or in a simple two-period setting, the repayment per unit loan – for which the demand for loans equals the supply. This puzzle is, however, no more complicated than for common sense to suggest a plausible solution: Those individuals who state their willingness to pay arbitrarily high interest rates may presumably cause problems when it comes to the repayment of credit, and such customers should rather be avoided by the bank. Rephrasing this argument in the language of economics textbooks, we expect the supply of credit to be backward bended , and if this is so, there may be no intersection of the demand and supply curves, such as illustrated in Fig. 6.1. Even if this argument may be simplistic, in particular because the market for financial services, including credit, is far from being a purely competitive one where supply and demand make sense, it does point to something important, namely the considerations of lenders when assessing the creditworthiness of borrowers. We saw already in Chapter 1 that this situation is one where asymmetric information is present in one form or another, and therefore it certainly merits a closer study. This closer scrutiny of the lender-borrower relationship ex ante , before it has material-ized, has two aims.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Routledge Library Editions: Monetary Economics

  • Various(Author)
  • 2021(Publication Date)
  • Routledge

    (Publisher)

  According to the availability doctrine, the loan rate of interest rises sluggishly when there is a decrease in loanable funds so that Credit Rationing occurs. In the 1960s, economists began to take an interest in explanations of Credit Rationing that do not depend on legal or institutional restrictions, but rather on market imperfections. Examples include Hodgman (1960), Freimer and Gordon (1962), Miller (1962), and Jaffee and Modigliani (1969). These works are the precursors to the equilibrium Credit Rationing literature with which this study is directly concerned. Following earlier work of his own and others! on "rational" explanations for Credit Rationing, Hodgman (1962) utilizes a partial equilibrium approach to examine negotiation procedures between borrowers and lenders that may lead to Credit Rationing. The author's discussion covers a variety of possible situations: (i) Whether the lender or the borrower dominates the bargaining process; (ii) Whether or not 11 Literature Review bargaining is continued and exhaustive; (iii) Whether or not loan size is continuously variable. Among his findings is that Credit Rationing occurs when loan size is continuously variable and bargaining is nonexhaustive. According to the author, uncertainty can prevent the bargaining process from reaching a solution on the Edgeworth contract curve. In this case, the lender maximizes expected utility by choosing an optimal loan rate at which the borrower cannot borrow as much as desired; the borrower cannot induce the lender to increase loan size by offering a higher loan rate. The author notes that this case may occur in the presence of bankruptcy costs that increase with the loan size made to the borrower. Although information asymmetry between the lender and the borrower is not explicitly introduced in the model, Hodgman's analysis clearly foreshadows the equilibrium Credit Rationing literature that emerged in the 1970s.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Money, Banking and Financial Markets in Central and Eastern Europe

  20 Years of Transition

  • R. Matousek(Author)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Instead, the demand for loans will exceed the supply and banks will deny credit to some borrowers who are observationally indistinguishable from those who receive loans despite their willingness 64 Financing Constraints in South Eastern Europe to pay the prevailing interest rate. For example, if the borrower bears no cost when project returns are lower than the debt obligation, the moral hazard argument can lead to Credit Rationing because the borrower may divert the funds to riskier project ex post (Stiglitz and Weiss, 1981), engage in asset substitution (Schwartz, 1981), exert an inappropriate degree of effort on the project (Aghion and Bolton, 1997; Ghosh et al., 2001) or even falsely declare bankruptcy (Williamson, 1986). Banks cannot distinguish these borrowers from better-quality ones because of information asymmetries, hence they will ration their supply of credit. The information asymmetry theories of Credit Rationing have often been criticised for assuming that banks are unable to distinguish between borrowers – given that banks are in the information processing business and have specialised expertise in analysing credit risk (Riley, 1987; Inderst and Muller, 2007). 1 For example, Riley (1987) criticises the work of Stiglitz and Weiss by arguing that as long as high risk and high return are positively correlated, the adverse effect of risk may be offset by a favourable effect of returns and, as the number of observationally distinct groups increases, Credit Rationing may not be an empirically important phenomenon. Milde and Riley (1988) develop the ‘bank screening hypothesis’ in which separating equilibria with no rationing is attained where banks screen their borrowers by offering larger loans to safer borrowers and by sorting out different risk classes. However, banks can separate small firms from large ones, firms in one sector from those in other sectors, etc.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  Equilibrium Credit Rationing

  • William R. Keeton(Author)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  III Moral Hazard and Equilibrium Credit Rationing DOI: 10.4324/9781315207223-3

  Introduction

  In Chapter I it was seen that when there is risk of default, competitive equilibrium in the market for bank loans is fully compatible with Credit Rationing, in the sense that each firm may receive a smaller loan than it desires at the interest rate charged by the bank. We also noted, however, that in the absence of interest rate ceilings a competitive equilibrium could not arise in which some firms were able to obtain loans while other, identical firms were not. The purpose of the present chapter is to show that equilibrium rationing may occur in this second sense when there is “moral hazard” in the lending process. This will be seen to have important implications not only for the efficiency of resource allocation, but also for the effectiveness of, monetary policy in controlling aggregate demand.

  In general, firms will have a variety of investment projects to choose from. Associated with each project will be a probability distribution of the future income or net cash flow generated by the investment. The firm’s expected profits from an investment—i.e. the expected surplus of income over debt repayment—will obviously depend on which project is chosen, as well as on the terms of the loan received. Similarly, as long as there exists a possibility of default on the loan, the bank’s expected profits will be a function not only of the loan rate it charges and the volume of credit it extends, but also of the particular characteristics of the project in which the funds are invested.

  In the case of any fixed-payment debt such as corporate bonds or commercial bank loans, the payment which the lender receives is a concave but not linear function of the total income generated by the borrower’s investment project. The lender receives all the income from the project when the outcome is less than or equal to the principal and interest on the loan, but does not share in any excess over that fixed amount. When the outcome of the project is uncertain, this feature of fixed-payment debt can give rise to an important conflict of interest between lender and borrower. If two investment projects yield the same expected total income but differ in “riskiness”—in the sense used by Rothschild and Stiglitz ([6]), that one project has greater weight in the tails of the probability distribution of its outcome—the expected income of the lender must always be lower, and the expected income of the borrower higher, for the riskier of the two projects. That is, the share of the borrower in the total expected income from the project will be an increasing function of its riskiness.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  Global Credit Review - Volume 4

  Volume 4

  • Risk Management Institute(Author)
  • 2014(Publication Date)
  • WSPC

    (Publisher)

  The bulk of the literature on consumer bank lending (and other forms of bank lending as well) focuses on bank management of customer risk by means of pricing the risk. Yet it is well known that banks also commonly control for risk by denying loan applications altogether. There are theoretical questions about why this is done. Credit rejection in full or in part may reflect market imperfections in which banks are unable to adjust pricing with sufficient flexibility (for example, according to Greer (1974), when usury laws are in effect). At the same time there is a literature that posits that credit rejection is likely to take place for some applicants in unregulated markets due to adverse selection. This is the position of much of the research on Credit Rationing, beginning with Stiglitz andWeiss (1981).

  Credit Rationing, whose literature is reviewed by Allen (1987), may be a plausible explanation for some forms of partial credit rejection, in which a loan applicant is rationed, but is not as persuasive an explanation for cases where credit is refused altogether. De Meza and Webb (1987; 2000; 2006), De Meza (1992) and others have described how banks ration credit quantitatively in order to control for problems associated with adverse selection and asymmetric information. Recent empirical papers on rationing include Drakos and Giannakopoulos (2011), Jappelli (1990), Munnell et al. (1996). In this paper, survey data of US households who have been rejected or partially rejected for credit are used to identify factors that appear to have influenced the rejection decisions.

  Numerous issues in credit markets can manifest themselves in either pricing or rejection rates or both. For example, if discrimination against a group exists, it is possible that it manifests itself in either pricing or in approval rates, or both. This is essentially the position of Brent et al. (1995), Munnell et al. (1996) andTootell (1993) for mortgage market discrimination. Much of the literature on credit rejection has been driven by concern with discrimination in mortgage markets, and particularly “redlining”.2

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  Issues in Finance

  Credit, Crises and Policies

  • Stuart Sayer(Author)
  • 2011(Publication Date)
  • Wiley-Blackwell

    (Publisher)

  6 COLLATERAL AND Credit Rationing: A REVIEW OF RECENT EMPIRICAL STUDIES AS A GUIDE FOR FUTURE RESEARCH Tensie Steijvers Wim Voordeckers 1. Introduction

  The use of collateral is a widespread feature of credit contracts between firms and financial institutions. The National Survey of Small Business Finance (NSSBF)1 conducted in 1998 revealed that, for 30.3% of the loans, business (or inside) collateral2 had to be provided. In 2003, the use of business collateral increased to 45% of the loans granted. In addition, the NSSBF of 2003 shows that for 53% of the loans granted personal (or outside) collateral was pledged, while in the NSSBF of 1987 only 28% of the loans required personal collateral pledging. The question why the use of collateral in credit contracts between financial institutions and small firms is a common feature has intrigued scholars for several decades.

  In general, the contractual relationship between these borrowers and lenders may be characterized by the presence of asymmetric information that may give rise to Credit Rationing. From a theoretical point of view, Credit Rationing occurs if, in equilibrium, the demand for loans exceeds the supply at the ruling price of loans (interest rate). In their seminal work, Stiglitz and Weiss (1981) conclude that there are no competitive forces in action to increase the interest rate in order to bring demand and supply together. If the bank would agree on a higher interest rate, its expected return would decrease due to informational asymmetries (Leland and Pyle, 1977). First, an adverse selection effect would be introduced: a higher interest rate will attract higher risk borrowers while lower risk borrowers drop out. Second, borrowers who receive a loan will prefer higher risk projects to low risk projects. This is the moral hazard effect. Finally, financial institutions cannot costlessly observe or monitor the behavior of the firm. A higher interest rate gives rise to higher monitoring costs to avoid that firms report a lower return than realized, insufficient to repay its debt. Theoretical models predict that the existence of information asymmetry gives rise to Credit Rationing if the information problem remains unsolved. Due to asymmetrical information, the expected banks' return increases non-monotonously when the interest rate is increased. So, banks would prefer rationing credit to opaque firms rather than increasing the interest rate.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  The Theory and Practice of Microcredit

  • Wahiduddin Mahmud, S. R. Osmani(Authors)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  5  Theories of microcredit

  Adverse selection and repayment enforcement

  Ever since the classic work of Arrow (1963) and Akerlof (1970), it has become well-known that when informational asymmetries exist, the market can behave in strange ways. In particular, bad products and bad clients may drive good products and good clients out of the market − a kind of market failure that has come to be known as adverse selection.1 In a couple of pioneering papers, Jaffe and Russell (1976) and Stiglitz and Weiss (1981) applied this idea to the credit market and showed that when lenders cannot distinguish between ‘good’ and ‘bad’ borrowers, the market-clearing interest rate might allow too many ‘bad’ borrowers and too few ‘good’ borrowers than is desirable from the lender’s point of view. In consequence, the lender might resort to Credit Rationing, leaving a part of the demand for credit unsatisfied.2 This would be socially inefficient, although it would be a rational response for the lender − a classic case of market failure.3

  Another endemic problem of the credit market is that even when the borrower may have earned enough return to be able to repay the lender, she may not want to do so, and the lender may not be able to do anything to enforce repayment. The lender’s inability to enforce repayment may stem from various sources, including the limited liability constraint associated with the absence of collateral. If the borrower does not have a tangible collateral that can be lawfully seized by the lender without incurring too high a transaction cost, the only conceivable option left to the lender is either to do something unlawful (such as threatening violence or seizing household assets that were not pledged as collateral), or to apply some kind of social pressure. The problem, however, is that while these options may be available, to some extent, to local moneylenders, neither option is really open to a formal lender who has his reputation to protect and the long arm of the law to contend with. Aware of this limitation, dishonest borrowers may choose to default even when they are able to repay. This is the problem of ex post moral hazard, also known as the problem of strategic default.4

  Sign up to read

  Learn more about book